The economy has nothing to do with why stocks move

Once you believe something, it is very hard to get it out of your mind. Those who have the power to create those beliefs thus have an awesome responsibility to get it right. And anyone who mentions the state of the economy in connection with stock prices is exercising that power.

And they are creating a belief system that is completely wrong.

Last week I spoke with two colleagues who asked me to explain how stocks could be going up given the state of the economy. The interesting thing about that question is its rote nature. People ask it without thinking because it is like a second grade school lesson that has been drilled into their heads. The mouth moves as if it had no connection to the brain – at least the analytical part.

When faced with evidence that there is no connection, people tend to ignore the evidence. That's because of kind of irrational decision-making algorithm called confirmation bias – in which people embrace information that reinforces their preconceived notions and ignore anything that undermines them.

For an example of confirmation bias, you have only to look at the comments section of almost any article written about President Obama. There are people who read the articles who firmly believe that he is not legitimately president. Therefore, any “evidence” that makes them feel that they are right – such as claims that Mr. Obama was not born in the U.S. – are widely embraced. And the image of his actual birth certificate is dismissed as a forgery.

While readers who do not share this belief may be chuckling to themselves with a feeling of superiority, some of them may hold fast to a different belief – that stocks go up when the economy is doing well and go down when it is doing badly.

For a look at why this idea is wrong, I present the performance of the stock market since the end of January 2009 when Mr. Obama took office. At that time, the S&P 500 index stood at 832 – since then, it has risen at a 16.9 percent annual rate to 1786. This is the second strongest performance in the financial markets in the last 70 years. The best performing market occurred under Bill Clinton – during which time stocks rose at an average rate of about 17.4 percent.

And in 2013, the S&P 500 has risen 25 percent.

But the economy has been doing poorly the entire time. Whereas, Gross Domestic Product under Bill Clinton grew at a 4 percent average annual rate and created an average of 230,000 jobs per month; under Mr. Obama, GDP has grown at about 2 percent annually and nonfarm payroll employment has grown from 132 million to 136.7 million at about 80,000 jobs per month.

Simply put, stocks have done extremely well in the last five years while the economy has neither grown much nor created many jobs. If you believe that stocks follow the economy, then your mind is concocting reasons why the economic numbers must be wrong.

Perhaps you are thinking that the stock market does not go up based on actual economic results but on expected future results.

If you are thinking that, then you must be able to predict the future. And that is not something that anyone can do with reliability.

Nevertheless, I do not expect readers to immediately give up on the theory that stocks move with the state of the economy. Why not? One theory that could now be tested by measuring brain activity in the regions where pleasure-inducing chemicals like dopamine or endorphin are released is that when people hear news stories or authorities comparing the stock market with the economy, they receive a dose of those pleasure inducing chemicals.

Therefore citing evidence of the disconnect between stock prices and the economy will not be sufficient. One thing that might help is to introduce a new theory that actually helps people make better investment decisions.

Unfortunately, the only way I know for sure to make better investment decisions is for you to have so-called information asymmetries -- access to market moving information that nobody else does. All the other theories of investment that I know of – buy stocks that are growing faster than the ratio of their price/earnings ratios, buy stocks when everyone is fleeing them, buy stocks that are trading at a price that is less than the liquidation value of their assets -- are too widely known to give you an edge.

And buying based on information asymmetries is often illegal.

So why does the theory that stocks move with the economy survive? It makes good economic sense for the financial industry. Every week more economic statistics come out. And odds are good that the numbers will be better or worse than expected. That will make some people want to buy and sell securities. And those transactions will boost financial industry commission revenues.

Resist all the bad theories and buy an S&P 500 index fund – it has low expenses, low fees, and lets you keep up with a market that is doing way better than the average high-fee hedge fund.Peter Cohan of Marlboro heads a management consulting and venture capital firm, and teaches business strategy and entrepreneurship at Babson College. His email address is peter@petercohan.com.